2011-03-18

It appears likely that the disaster in Japan will cause shortages of a lot of components needed for manufacturing various products, and this will quickly lead to reduced output of a lot of products in plants all over the world because most manufacturing operations use "just in time" inventory management and therefore don't keep a big supply on hand of the components they need to make their products.

The reduced supply of a number of products will then cause a rise in the prices of those products under the laws of supply and demand.

The rising prices of a number of products, especially when coupled with rising energy prices due to the disruption in the Middle East, will lead many people to conclude that inflation is picking up. This will lead to increased pressure on the Fed to tighten.

If the Fed does indeed tighten monetary policy in the face of these supply-shock rising prices it could trigger a second recession.

The key point is that rising prices due to supply shocks are *not* an indication of an overheating economy that needs to be reined in using monetary policy. They are just an indication of real shortages of real goods.

Trying to fight price increases caused by real shortages by tightening monetary policy is not a smart choice. If the Fed lets shortage induced price increases run their natural course the rising prices will reduce demand for the particular goods in short supply until equilibrium is reached, and other industries will not be directly affected. If the Fed tries to fight shortage induced price increases by tightening monetary policy the demand for all goods, even those not in short supply, will be reduced, and all industries will see a reduction in demand, i.e. a recession.